Beware of another oil shock

After hitting a low of around $32 last December, the price of a barrel of oil has risen above $70. While the net effect of this will lead to renewed inflation and hitting our wallets, what is the medium-term outlook for oil? All predictions are risky, but it is likely that prices will go right back up into the $100 level, resulting in many attendant problems for the world economy.

If you look at the really big picture, global energy futures are complex. On the one hand, the world probably will not run out of oil (and oil-like substances such as shale, tar sands, liquefied natural gas, liquefied coal) in the immediate future. Besides, according to the fundamental laws of physics, there is plenty of energy available in the current known reserves of various sources.

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Research by Harvard University suggests, for instance, that the world’s conventional oil and gas alone contains 1,000 terawatt-years worth of energy; coal has 5,000; the amount of solar energy falling on the earth every year is 30,000; and our total current use worldwide is only 15 terawatt-years per year. The trick, of course, is in converting this potential into actual available energy.

On the other hand, there is increasing concern about greenhouse gas emissions and global warming. As a result of conservation and greater efficiency, it is possible that energy demand growth may decline. Nevertheless, conventional energy sources will continue to predominate and renewables will not be a major factor even in 20 years’ time.

For instance, the Organization for Economic Co-operation and Development’s (OECD) International Energy Agency (IEA), in its World Energy Outlook 2008, sees “more of the same: a vision of a laisser-faire fossil-energy future”. It considers a reference scenario, which suggests that world energy usage will grow from 11,730 million tonnes of oil equivalent (mtoe) to 17,010 mtoe in 2030, an increase of 45%.

An immediate implication of this reference scenario is that oil prices will rise again. The recent volatility of oil prices was unexpected (from $147 last July to $32). Oil prices plunged as a result of the recession-induced collapse in worldwide demand for goods, and thus for trade and shipping. But with oil plumbing new lows, many people went back to their profligate use of energy. The lessons of the last oil shock were not internalized, and demand simply rose again.

Furthermore, it is quite clear that the producing countries have great incentives to ensure a much higher “normal” or “base” price, because they have become addicted to the windfall transfer of trillions of dollars to them, courtesy high prices. The breakeven prices required by members of the Organization of Petroleum Exporting Countries (Opec), according to The Wall Street Journal Asia, are as follows: Iran $90, Bahrain $75, Oman $77, Saudi Arabia $49, Kuwait $33, Qatar $24, the UAE $23.

While the actual cost at the well-head of oil may be lower (some experts say that it costs Saudi Arabia $1-2 a barrel to dig oil out of the ground), the budgetary price that Opec countries live by is much higher, and they will not be able to sustain their spending below a certain minimum price. Thus Opec will observe production quotas until the desired pricing level is reached.

Observers such as IEA suggest that the “natural” price of oil is around $85-100 (in 2009 dollar terms), and that prices will reach this equilibrium level in the near future. The extreme volatility in prices, according to them, is acting as an inhibitor to investment in Opec countries, and therefore most likely will lead to supply reductions in the long-run, as existing oil wells get exhausted.

They argue that the era of peak-oil has not arrived, contrary to Cassandra-like predictions (called “Hubbard’s Peak”). Opec dismisses these concerns by saying, “Resources are plentiful.” Oil company officials suggest that new oil supplies will continue to come online. Therefore, they do not see a fundamental constraint on oil availability from the supply side, although actual future capacity to deliver may be affected in future by failure to make investments today.

The world is not running short of oil or gas just yet, they say, and there is no oil bust. Incidentally, experts concur that Opec members will dominate supply, and that non-Opec (such as Russian) oil will have limited impact.

There is still a significant amount of recoverable oil, including extra-heavy oil, oil sands and oil shale, although the cost of recovery and of downstream products may be high. However, field-by-field declines in oil production are accelerating and barriers to upstream investment could constrain global supply. This is one of the arguments made about the ultimately harmful effects of oil prices being “too low”: major projects are being cancelled or put on hold.

Thus, barring some extraordinary breakthroughs in renewables, oil prices will go right back up to the $100 level soon as soon as demand recovers. We had better be prepared for more sticker shock.

Rajeev Srinivasan is a management consultant focusing on strategy, innovation and energy. Comment at theirview@livemint.com